Russia’s Energy Export Diversification: Between Europe & Asia

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Russia is a global energy leader with substantial energy reserves. The former USSR once ranked as the world’s top oil producer, and to it, energy had strategic importance and a guarantee of existence. Historically, hydrocarbon revenue has been of significant strategic importance to Russia’s nation-building and sovereignty, which has rested on its ability to unite various peoples under a single power and maintain influence over immediate neighbors. However, relying on hydrocarbons as the main source of government revenue has exposed Russia to the significant fluctuations in the hydrocarbons market. Yet, achieving Russia’s objective as the world’s largest primary energy exporter by 2035 requires infusions of foreign investments, reforms and importantly securing markets.

To Russia’s west, Europe’s energy import dependence has increased over the past 20 years. These imports have increasingly come from a smaller set of countries, which, has exposed Europe to supply disruptions and has even endangered the independence of its foreign policy. The Ukraine crises in 2006, 2009 and 2014 have not only highlighted the insecurity of supply for Europe but also Russia’s lack of customer base diversity and insecure routes.

Russia’s Nord Stream and South Stream pipelines were designed to overcome the Ukraine route insecurity. However, Europe’s objectives to diversify away from Russia has scrapped the South Stream after the Crimea crisis and put restrictions on Nord Stream. Furthermore, Europe has also supported the entry of Azeri gas via the Southern Corridor. On the other side, Russia’s Turkish Stream was its answer to the cancellation of South Stream and will further strengthen Turkey’s position as an energy hub.

Russia is also increasingly facing east to further diversify away from Europe. In 2016, Russia surpassed Saudi Arabia as China’s largest crude exporter. It is also allowing Russia to compete early with LNG in Asia and secure Chinese financing. Russia can also greatly assist in China’s transformation away from coal, thus, securing a global environmental victory.

The Japan-Russia relations are warming up since the Fukushima crisis despite a longstanding territorial dispute over the Kurils islands. Plans to build a gas pipeline to Hokkaido island is progressing. And in Central Asia, China has been exploiting Russia diminishing position to secure its presence there via military and economic aid in order to boost its energy imports from the region.

Future geopolitical drivers in this topic will include: how successful would the Trump-Russia rapprochement be; the ability of Russian government to maintain substantial levels of hydrocarbon revenues and profitability; how the EU policy-making will progress in face of diverse energy interests by its members; and the role Turkey will play in its unstable region as an energy hub.

Implications of Hydrocarbon Reliance

However, such a strategy had lead to energy becoming a source of revenue and vulnerability. The USSR collapse came shortly after the oil price fall of 1986. Today, reliance on hydrocarbons impacts revenues and domestic consumption. When oil prices plunged from US$147 to US$34 a barrel post the 2008 financial crisis, it caused an 8% contraction in the Russian economy, the highest among G20 nations. In 2014, Russia exported 45% of its total 1,306 Mtoe of energy produced and imported a mere 27 Mtoe. The total primary energy demand of 686 Mtoe is mostly covered by natural gas, crude oil, and coal at 54%, 21%, and 15% respectively. The IEA forecasts minor changes to the Russian consumption mix with almost no significant changes to the current shares. Having the world’s second-largest gas reserve and third highest oil production behind the United States and Saudi Arabia, Russia has little incentive to switch to other sources of energy.

Figure 1: Ruble devaluations helps maintain production cost margin in Russia (Source: IMF)

In 2015, Russia faced sharp economic contraction resulting from (1) foreign sanctions post-Crimea’s annexation and (2) low oil prices. For each US$ 1 drop in oil price, the country lost US$ 2 billion in revenues. The government devaluated the Ruble (Figure 1), injected liquidity in the banking sector, released stimuli packages, and practised fiscal discipline. However, the IMF warns that these measures might trap Russia in an economic recession, as recovery proves harder than expected. Furthermore, a weakened Ruble, although good for export, might ignite social tensions. The agency has also predicated on an increasing proportion of revenues to come from hydrocarbon sales meaning sustained exposure to changing energy dynamics (Table 1).

Table 1: Russia’s Production & Revenue Forecasts (Source: IMF)

By 2035, BP expects Russia to remain the world’s largest primary energy exporter with 4% of global demand. Accomplishing that requires infusions of foreign investments, transparency empowerment and reducing the centrality of revenue endowments, but most importantly securing markets. Russia’s strategic location gives it access to huge markets: the European Union to its west and China, Korea and Japan to its East. However, tensions and geopolitics on both fronts have and will play a substantial role in securing these markets.

EU Energy Import Dependency

Between 1995 and 2015 the EU GDP rose from 7.28 to 14.6 Trillion Euro accompanied by an improvement in energy efficiency consumption (Energy Intensity dropped from 174 to 122 toe/M Euro). However, this consumed energy has been coming more from outside the EU. The EU has imported 55% of the energy it consumes in 2014 compared to 44% in 1995, and its energy import dependency to certain fuels has also increased: crude oil to 88% (73% in 1995), Natural Gas is 67% (43% in 1995), and Coal became 68% (30% in 1995).

These EU energy imports come from a concentration of countries (Gas: 38% Russia, 32% Norway and 12% Algeria. Oil: 31% Russia, 13% Norway and 9% Nigeria). In addition, six member states depend on Russia as a single external supplier for their entire gas imports and three of them use natural gas for more than a quarter of their total energy needs.

This high level of dependency makes the EU vulnerable to disruptions of supply and inflexible pricing regimes that could give rise to geopolitical tensions. During 2006 and 2009 Russia’s Gazprom cut gas supplies through Ukraine, in the middle of winter, in relation to a number of disputes over supplies, prices, and debts. Gazprom claimed that Ukraine was not paying for gas. Countries in East and Southern Europe were left without supplies for a few weeks as a result. In 2014, again, Russia cut off supplies to Ukraine for similar reasons. The escalation of that crisis ended with the annexation of Crimea.

EU Energy Security

As a result, the debate within the EU regarding energy security intensified. The EU needed a strategy for energy security, which promotes resilience to energy supply disruptions in the short term, and, reduced dependency on particular fuels, energy suppliers and routes in the long term. In this context, the EU found it imperative to limit its dependence on Russian gas as both an economic and political objective. The EU also felt that their lack of energy independence resulted in a lack of foreign policy independence.

Figure 2: Ukraine Gas Transmission System (Source: NGUU)

Although the EU has always seen this as a serious energy security risk, it was not easy to overcome it. The cost of Russian gas supplies remained lower due to lower transportation cost, competition from coal and diversion of LNG to the Asian markets due to higher gas prices. Notably, two resulting policies are worth mentioning here: the Oil Stock Directive, which requires each member country to maintain ‘at least 90 days of net imports or 61 days of consumption, whichever is higher’ of oil and/or petroleum products due to their high importance in transportation. And the Third Energy Package, which requires the separation of gas production, transportation and sale to prevent gas suppliers from dominating the infrastructure.

Figure 3: Nord Stream & South Stream (Source: nord-stream.com)

Diversification from Europe

On the other side of this equation, Russia was also looking at the insecurity of its energy routes and to its dependence on a single large buyer, and was, therefore, keen to diversify its customer base and routes in the wake of western sanctions against Russia due to the annexation of Crimea during the dispute with Ukraine. Russia’s plan rested on two pillars: Nord Stream and South Stream.

Figure 4: Southern Corridor

Nord Stream is a 1200 Km gas pipeline between Russia and Germany that delivers 55 bcm/year, was meant to bypass the Ukraine route directly into Germany which has been Russia’s single biggest gas importer in the EU (31% in 1994 and 24% in 2014 as a percent of EU share). The Nord Stream II project is a proposed expansion of Nord Stream. While, the South Stream pipeline was designed to bring 63 bcm/year, bypass the Ukraine route, to land in Bulgaria via the Black Sea, and supply Bulgaria, Serbia, Hungary, Slovenia, and Italy.

Europe’s Response

The EU had concerns that gas would be used by Russia as a political tool, especially, against members of the EU that are highly energy import-dependent. Also, countries on previous routes will have to build new infrastructure to accommodate the new routes, and will also lose pipeline rent they used to receive from Russia.

So, in the wake of the Crimea crisis and the resulting sanctions on Russia, the EU used its Third Energy Package to put further hurdles on the project, which in the end led to it being scrapped by Russia. Furthermore, the EU put restrictions on the expansion of the Nord Stream via OPAL, a 36 bcm/year pipeline between Germany and the Czech Republic linking the Nord Stream to Europe’s gas network, by requiring Gazprom to reserve up to 50% of the OPAL gas pipeline’s capacities for gas transportation by independent gas suppliers. Although, in October 2016, the EC decided to allow Gazprom the use of the remaining 50%, however, later in December 2016 the European Court suspended that decision.

At the same time, the EU supported the Southern Corridor as one of Europe’s solutions to diversification away from Russian gas. This system of pipelines aims to bring 16 bcm/year of Azeri gas from the Caspian Sea into Europe. It consists of three pipeline projects: South Caucasus Pipeline (SCPX) – Azerbaijan, Georgia, Trans Anatolian Pipeline (TANAP) – Turkey and Trans Adriatic Pipeline (TAP) – Greece, Albania, Italy.

Figure 5: Turkish Stream (Source: Gazprom Export)

As a result of the restrictions put on the South Stream that had led to its cancellation, Russia announced the Turkish Stream pipeline that runs under the Black Sea between Russia and Turkey and was designed to bypass both: the Ukraine route and the EU restrictions by laying the pipeline just up to the EU border. For Turkey, the Turkish Stream will increase Russian gas supplies, on top of the existing Blue Stream pipeline, and will allow Turkey to play a more important role as an energy hub. The EU cannot use the Third Energy Package to prevent the construction of the pipe since Turkey is not part of the EU.

Figure 6: IEA Additional Natural Gas Demand Forecast (Source: IEA WEO 2016)

Diversification East

With geopolitical tensions high on the European front, Russia is increasingly looking eastward. China’s large population, increasing consumption and poor efficiency has kept the country energy-hungry. Supply security in China means having the capability to achieve long-term access to energy while protected from risky middle-eastern suppliers and fluctuating prices. In 2016, Russia overtook Saudi Arabia as China’s largest oil exporter at 1.05 mb/d compared to 1.02 mb/d a year earlier. The extra shipments were ordered by small-scale refiners or ‘teapot’ refiners. In contrast, Saudi Arabia ships to larger state-owned refiners. Incentives were flexible and faster small shipments delivered from geographically close eastern ports.

Figure 7: Russian Energy Infrastructure Expansion East

In 2017, Russia plans to increase exports to China from Eastern Siberia via new upgrades. Parallel to the East Siberia Pacific Ocean Pipeline (ESPO), which has a maximum capacity of 1.6 mb/d of crude oil, CNPC and Gazprom are finalizing the construction of the US$ 400 billion Power of Siberia Pipeline with a 30-year gas deal. This pipeline fulfils CNPC’s plans for an Eastern gas route to China. On the other end, the proposed Altai Pipeline is aimed at creating a route for Western Siberian gas to China’s Xinjiang province empowering Gazprom to switch supplies from Europe to China if needed. For this pipeline to materialize, Chinese reluctance must be reversed by offering attractive terms.

Pivot to China: Benefits & Challenges

Pivoting into China allows Russia to diversify customers and compete with LNG in Asia. Also, it provides Russia with the opportunity of securing Chinese financing for oil and gas development in the east. Nevertheless, such a venture is not challenge-free as Russia will have to compete in a well-supplied market. Furthermore, while coal remains the backbone of power generation feedstock, Russia has the greatest prospect to benefit from China’s long-anticipated coal replacement by exporting cheaper pipeline gas. Therefore, Russia might win the world’s recognition for the greatest climate change achievement especially with a climate-reluctant Trump administration and indeed contrary to today’s European criticism for the military campaigns in Crimea and Syria. An unknown factor persists, which is China’s capability to become a world natural gas producer by exploiting Shale gas (Figure 7).

Figure 7: Chinese natural gas supply forecast (Source: 2017 BP Energy Outlook)

Japan & India

Despite long-standing geopolitical tensions between Russia and Japan, gas production facilities and transmission centres are rapidly being developed by Gazprom on Russia’s Sakhalin Island and the Kamchatka peninsula and Sakhalin is exporting oil and LNG to Japan. Moscow and Tokyo have never signed a peace treaty to end hostilities from WWII due to a century-old dispute over the Kurils Islands that stretch between the two countries. This had affected their political, as well as, trade relations in the past. However, there has been a warming up of the relations between the two countries due mainly to the post-Fukushima disaster increase in Japan’s needs for gas, Russia’s expansion of oil supply eastward as well as its plans to build a gas pipeline between Sakhalin and Japan’s Hokkaido island. In addition, Japan does not want to see a Russia-China axis forming, while Russia wants to see multiple customers on its eastern borders to diversify away from China. Although, the Crimea crisis had suspended temporarily that momentum when Japan joined the sanctions against Russia, things have restarted again and Putin’s December 2016 visit to Japan has resulted in cementing that relationship further thus bypassing the Kurils issue.

Russia permitted the sale of US$ 1.29 and 2.02 billion stakes in Vankorneft and Taas-Yuryakh-Neftegasodobycha operations of Bashneft in East Siberia to Indian joint ventures with the objective of financing the federal budget deficit. Initially, it was offered to Chinese companies but Russia aims at a higher future share in India’s long-term oil demand. Supplies to India and Japan are signals to China indicating Russia’s wish not to only rely on the largest buyer in Asia.

Central Asia

Today, increased supplies to China may seem like the logical answer to diversifying away from Europe. Yet, Russia will have to compete with a well-established Central Asian oil and gas routes for market share in China. Proximity and shared borders with resource-rich Central Asia drove Beijing to invest heavily in linking itself to the region’s resources. In the past, 77% of Turkmenistan’s gas went to Russia. Today, Turkmen gas has boosted the Chinese gas consumption by 2% through the 55 billion cubic meters capable Central Asia-China Gas Pipeline. Furthermore, with 40 million tons of oil per annum, the Kazakhstan–China Oil Pipeline supplies Xinjiang province in China. In return, Beijing has offered billions of dollars in infrastructure, military and socio-economic aid.

Future Geopolitical Dynamics

Trump Rapprochement: With the United States poised to become a net energy exporter in the future; will the relationship with Moscow be based on cooperation or competition? For Mr Trump’s chief diplomacy officer — Exxon’s former CEO Rex Tillerson, to succeed, he must lift the sanctions, practically allowing Russian and Western companies to freely work together again. But, how will China react? Moscow needs both the US and China to develop green fields in East Siberia and the Arctic shelf.

Revenue and Profit Sustainability is crucial to the financial survival of Russia. Will Russia be able to maintain adequate levels of revenues and profits from hydrocarbons? Will Russia be able to maintain lower energy production costs? How will Russian future deals evolve under the LNG threat? Russia’s Reserves are maturing, its facilities and Soviet-era pipelines are ageing, how to attract investments? How much and when will the US export to Europe, Asia, and Central America? What effects will Australia’s LNG export to Asia have?

The European Union: What is the future of policy cohesion in the EU? Will the post-Brexit, post-Trump wave of nationalism, as well as, competing for energy needs by EU members affect the efficiency of the collective policy of the EU?

Turkey: How will the role of turkey evolve as a transit route and a market hub in an unstable region?

Conclusions

Russia is investing heavily in creating an energy conduit to Asia as a measure of diversification away from Europe. The main driver is the Kremlin’s wish to secure consumers and maintain crucial hydrocarbon revenues. Nevertheless, pivoting to China will be challenging due to the competition of alternative supply routes and anti-China White House rhetoric. Yet, long-term internal threats are a ticking bomb combination of Dutch disease and the resource curse.

References

  • Russian Energy Issues in A Volatile Environment, Oxford Institute for Energy Studies’ forum publication.
  • The Past, Present, and Future of Russian Energy Strategy, Stratfor Geopolitical Weekly.
  • 2016 World Energy Outlook, International Energy Agency.
  • BP 2017 Energy Outlook.
  • The 2016 EU Energy Pocketbook.

 

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Yesar al-Maleki is an energy economist and a Middle East observer with extensive knowledge of the intertwining subjects of energy, geopolitics, and economics in the region.
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Jalal Yaqoub is an independent oil and gas advisor and the former Deputy Finance Minister of Yemen.

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